Industrial Bankers Securities Corp. v. Higgins

Appeal from the District Court of the United States for the Southern District of New York.

Author: Hand

Before L. HAND, AUGUSTUS N. HAND, and CHASE, Circuit Judges.

AUGUSTUS N. HAND, Circuit Judge.

This is an appeal by the defendant, Collector of Internal Revenue, from two judgments recovered by the plaintiff against him for $138,490.17 and $51,421.98 respectively, together with interest and costs. The judgments were based on claims of the plaintiff, Industrial Bankers Securities Corporation, for income taxes alleged to have been overassessed against it for the years ending September 30, 1932, and September 30, 1933. We think that the judgments were right and should be affirmed.

The plaintiff, a Delaware corporation, was organized on November 7, 1926, for the purpose of acquiring all of the stock of four corporations, of which one Noteman was then the sole owner, subject to an interest he had given to his wife, and of managing, financing and directing the business of the four corporations as wholly owned subsidiaries. Upon the organization of the plaintiff all of the stock of the subsidiaries was transferred to it and in consideration of such transfers $515,000 of the plaintiff's common stock was issued to Mr. Noteman for his interest, and $100,000 of the preferred stock was issued to Mrs. Noteman for her interest in the stocks transferred. He thus became the sole owner of all the common stock issued by the plaintiff and, as such, exercised his power to direct and control its business. The plaintiff, as thus controlled, proceeded to direct and control, as well as to finance, the business of its subsidiaries, as Mr. Noteman had previously done as an individual. The number of subsidiary corporations increased from four to eight by 1932 and one more subsidiary was added in 1936. Their business was a socalled small loan business carried on pursuant to provisions of the "Uniform Small Loan Law" under the statutes of Pennsylvania, Massachusetts and New York where the various subsidiaries were operated.

From the time the plaintiff was organized the small loan business continued to grow and as a result more money was constantly needed to finance the subsidiaries so that they might make desirable loans. Efforts on the part of the plaintiff to sell additional stock and to market long term securities in order to procure funds that might be furnished to the subsidiaries did not result in sufficient new capital to meet their needs. While it had been able to borrow money from banks and from Mr. Noteman, as its business increased, a less expensive and more advantageous method of financing the subsidiaries was to accumulate a large part of such dividends as were paid to it by its subsidiaries and to make loans to them out of that surplus without interest.

The principal development and growth of the business of the plaintiff and its subsidiaries resulted from plowing back into that business surplus earnings that were not required to pay the dividends declared to its stockholders. Dividends of either 10% or 11% were paid on the preferred stock (the maximum to which that stock was entitled) and of 6% or 7% were paid on the common stock. The surplus earnings accumulated by the plaintiff were made available to the subsidiary companies through loans in such amounts and in such proportions as the plaintiff, which through stock ownership was in control of those companies, deemed advantageous to the operating units.

In 1931 the financial depression began to affect the small loan business of the subsidiaries. In the spring of that year the loans receivable by them were about $1,400,000, on September 30, 1932 they had dropped to about $1,000,000 and on September 30, 1933 to about $840,000. This was due to a business policy which forbade loans to persons who were unemployed. The depression was also accompanied by a drop in the net earnings of the subsidiaries from $276,494 for the year ending September 30, 1931, to $207,000 for the year ending September, 1932, and to $122,000 for the year ending September, 1933.

With a surplus accumulating in the hands of the subsidiaries because of the repayment to them of their small loans and with the general contraction of the business, the question arose as to whether this surplus should be paid out by the subsidiaries in dividends to the parent corporation and held by the latter to await the needs of a normally growing business or should be retained by the subsidiaries for the same purpose. Mr. Noteman, who was the directing head of the enterprise, believed that the depression was bound to end before a great while and that the surplus would then be required to meet the needs of the business. But he was not satisfied to have the funds lying idle pending an anticipated recovery and thought that if they were temporarily invested in common stocks at the low market prices then current an advantageous profit would be realized. Consequently he caused the subsidiaries to declare dividends from the surplus, caused the plaintiff to pay off its bank loans and to invest amounts not needed for dividends on its own stock in common stocks which it purchased between October, 1931, and the spring of 1933 at a cost of $530,841.99.These stocks were all sold by July, 1935, at a profit of $350,000.

The business of the subsidiary (or operating) companies revived after September 30, 1933 so that the loans receivable by September 30, 1934 became $1,321,277, by September 30, 1935 $2,052,405, 405, by September 30, 1936 $2,557,038 and by September 30, 1937, $3,339,157. During the period preceding the final sale of the stock holdings Noteman thought that it was unwise to sell the securities faster than they were actually liquidated for he could obtain bank loans at only about 4% per annum. He, therefore, arranged extra financing of the operating companies through bank loans instead of by selling the stocks in which the surplus was invested during the time when it was thought inadvisable to liquidate them completely.

The Commissioner of Internal Revenue held that the plaintiff had been availed of to permit unlawful accumulations of surplus to prevent the imposition of surtaxes in the years 1932 and 1933 upon its single common stock holder Noteman. Accordingly deficiencies were assessed against the plaintiff for both years under Section 104 of the Revenue Act of 1932, 47 Stat. 195, 26 U.S.C.A. § 104 note. The portions of Section 104 under which the Commissioner assessed the deficiencies were the following:

"Accumulation Of Surplus To Evade Surtaxes.

"(a) If any corporation however created or organized, is formed or availed of for the purpose of preventing the imposition of the surtax upon its shareholders through the medium of permitting its gains and profits to accumulate instead of being divided or distributed, there shall be levied, collected, and paid for each taxable year upon the net income of such corporation a tax equal to 50 per centum of the amount thereof, which shall be in addition to the tax imposed by section 13 and shall be computed, collected, and paid upon the same basis and in the same manner and subject to the same provisions of law, including penalties, as that tax.

"(b) The fact that any corporation is a mere holding or investment company, or that the gains or profits are permitted to accumulate beyond the reasonable needs of the business, shall be prima facie ...

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